Summary:
Secondary market refers to the market where trading of stocks takes place. It facilitates price discovery, promotes diversification and offers liquidity provision. Stock exchanges and over-the-counter markets are two types of secondary markets.
If you are a stock market investor, you must have heard of the term secondary market. Have you ever wondered what the secondary market means and its importance to you as an investor? If yes, this blog will help you understand the nitty-gritty of a secondary market. Let’s start.
What is a secondary market?
Simply put, the secondary market is the market where trading of securities takes place. Think of it as a platform where people can buy and sell stocks after being issued in the primary market. Once a company conducts its initial public offering (IPO) and the stock gets listed, you can trade in it in the secondary market.
Functions and advantages of a secondary market
The secondary market plays a pretty vital role in stock markets. Some of its major functions and advantages are:
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Provision for liquidity
Liquidity is the ease with which you can convert an asset into cash. A secondary market enhances your provision of liquidity as it allows you to buy and sell stocks efficiently and quickly. This flexibility allows you to get money whenever needed.
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Price discovery
Forces of demand and supply help determine the price of stocks in the secondary market. The interaction of buyers and sellers help establish the market price of a particular security. This price discovery process leads to transparency and fairness in valuing stocks and other assets.
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Facilitates trading
It’s the secondary market where you can trade stocks freely without the intervention of the issuing company. It serves as a commonplace for retail and institutional buyers and sellers to trade.
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Promotes diversification
Diversification is one of the fundamental investing principles. It helps mitigate risk by spreading your investments across different financial assets. The secondary market helps you achieve the desired diversification by investing in different financial instruments such as stocks, bonds, debentures, etc.
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Capital formation
Though it’s the primary market from where companies raise capital directly, it’s the secondary market that supports indirect capital formation. By providing a platform for trading in securities issued in the primary market, it encourages investment.
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Offers an exit gateway
If you are not happy with a stock’s performance and want to sell it, the secondary market provides you with an exit gateway. It’s the secondary market that provides you the ability to realise gains or cut losses as per changing market conditions.
Types of secondary market
There are primarily two types of secondary market. They are:
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Stock exchanges
Stock exchanges are centralised platforms where buying and selling of stocks take place. India has two prominent stock exchanges - the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). Transactions on stock exchanges take place under strict regulations and mechanisms are placed to ensure investors’ safety.
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Over-the-counter (OTC) market
OTCs are decentralised marketplace where investors trade among themselves. There’s a lack of regulatory oversight in OTC markets and hence they carry higher risks. Also, liquidity in OTC markets is less than stock exchanges as it’s less regulated.
Example of a secondary market transaction
Here’s an example of how a secondary market transaction takes place:
- You want to purchase stocks of a certain company, say ABC Ltd.
- You find out a seller who owns the stocks of ABC Ltd and not directly from ABC Ltd itself
- You place an order and when the price of the seller matches that of yours, the trade is executed
- You get the shares of the company in your Demat account within T+1 day
To engage in secondary market trading, you need to have a Demat and trading account with a registered brokerage house.
Disadvantages of a secondary market
The secondary market has its fair share of disadvantages. These include:
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Price volatility
Stock prices in the secondary market can be pretty volatile. Various factors including economic conditions, company-specific news, and market sentiment, can lead to significant price swings. This can result in losses for you as an investor.
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Lack of control
You may have a limited control over the price at which you want to buy or sell securities. In other words, the price may not always align to your desired buying or selling cost.
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Emotional decision-making
As price swings could be wild in a secondary market, you can end up making investment decisions based on emotions, such as fear and greed. Emotional decision-making can lead to impulsive trading, leading to sub-optimal returns.
Summing it up
The secondary market is an important cog in the wheel of stock markets. Prudent and active participation in secondary markets can help you in long-term wealth creation. Happy investing!